The cost of inflation depends on two cases; perfectly anticipated inflation and unanticipated inflation. Anticipated inflation is defined when individuals are able to make accurate predictions of inflation, they can take steps to protect themselves from its effects. Also, trade unions might use their bargaining power to negotiate for increases in money wages to protect the real wages of union members. Households may want to switch savings into accounts offering a higher rate of interest or into other financial assets where capital gains might exceed price inflation. Businesses can adjust their prices and lenders can adjust interest rates. However, businesses may also seek to hedge against future price movements by transacting in “forward markets”. For example, many airlines such as Bahamas-Air may buy their fuel months in advance as a protection or ‘hedge’ against fluctuations in world oil prices.
In Contrast, When inflation is unanticipated, individuals do not realize that they should protect their real purchasing power against a rising price level until the price level has already risen and their real purchasing power has already fallen. In this instance, there will be gainers and losers, in terms of purchasing power, from the inflation. In general, unanticipated inflation causes a misallocation of resources. Firms, unions, banks, will push prices and wages up. Those who can do it best will cause a misallocation of resources. For example suppose workers at manufacturing companies in the Bahamas wage increases, and public employees don't. Then, resources (labor) will be reallocated due to the relative market power of the different workers. But more importantly, lenders such as Banks will lose with respect to borrowers, giving individuals an incentive to borrow. For instance, when Bahamian people take out mortgages in order to buy houses at fixed interest rates, they end up paying back less in real terms than they had contracted for, wealth is then...
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